7/08/2008 @ 5:25PM

Innovating During A Recession

Whether or not the U.S. or the global economy meets an economist’s definition of a recession, it is clear that corporations are currently tightening their collective belts. What implications does this have for innovation?

There appear to be two basic camps on this question. One side argues that companies should redouble their innovation efforts in recessionary times. In March,
American Express
CEO
Ken
Chenault
Ken Chenault
was quoted in Fortune saying,“A difficult economic environment argues for the need to innovate more, not to pull back.”

It’s probably not a huge surprise that our perspective is that the worstthing to do in a recessionary period is to stop innovating. Innovation remains a critical lever for companies to achieve their long-term strategic objectives.

But companies do need to be very thoughtful about how they approach innovation, because the margin for error decreases as times get tough. Paradoxically, there can be good news for companies innovating in a recession.

Constraints can enable innovation. As an example, think about the retailing industry. Over the past 100 years, the industry has been a source of significant business-model innovations, such as Wal-Mart‘s
discount model, Costco‘s
warehouse-club model, Inditex’s Zara’s fast-fashion model, and Amazon.com‘s
collect-cash-before-you-contact-suppliers model.

Why is the retailing industry such a rich source of business-model innovation? At least one explanation is scarcity. The basic retailing model makes it very difficult for retailers to innovate the features and functionalities of the products they sell. Thus, they innovate the way in which they sell those products. This constrained environment funnels creativity to where it can best be applied, creating powerful waves of growth.

Similarly, why are entrepreneurs so good at rapidly iterating their strategies? Is it because they just are more flexible than people inside established companies? We don’t think so. Entrepreneurs have no choice. If they don’t rapidly change course, they will run out of money. Large companies can often curse innovation efforts by being too patient or spending too much money. The discipline forced by bad times can allow companies to impose sharp constraints that inspire creativity.

Previous dips in the economic cycle have not been hostile to disruptive innovation–the convenient, accessible, affordable innovations that transform existing markets and create new ones. Consider the year 2001, by all accounts a rough year. It was clear that the Internet bubble had burst. The Nasdaq index was down close to 30%–and that was before the Sept. 11 terrorist attacks.

But was it a bad year for disruption? Quite the contrary. In 2001,
Procter & Gamble
launched Crest WhiteStrips, which quickly became a $200 million product.
Apple
launched the first version of its iPod. Pfizer Consumer Healthcare–now owned by
Johnson & Johnson
–rolled out its Pocket-Packs product.
EnerNOC
, whose disruptive demand-management services have expanded energy capacity without building a single new plant, was founded. All in all, our research identified at least a dozen specific disruptive developments in the U.S. alone.

More broadly, we assembled a database of the 173 disruptive developments in the U.S. from 1968 to 2003. Small sample size caveats apply, but our analysis found the correlation between the number of disruptive developments in a given year (either new companies forming or disruptive offerings launched by incumbents) and growth of real U.S. gross domestic product was a weak 0.17.

In the period from 1990 to 2003, the correlation between the number of new disruptors and GDP growth was mildly stronger (0.29), but still far lower than the correlation between the net number of new businesses created and real GDP growth (0.46).

With this as a backdrop, we offer the following three pieces of advice for leaders assessing their innovation options in increasingly turbulent times.

No. 1: Don’t Stop Innovating

We strongly believe that curtailing innovation efforts in tough times is a long-term strategic mistake. A barren innovation pipeline increases the risk of long-term competitive disadvantage. As the economic cycle inevitably shifts upward, companies who have dropped the innovation ball will find their fortunes sagging just as the economy surges.

Research and development or other innovation-related areas are natural places to look when searching for areas to curtail in order to meet stricter budget targets. After all, these investments are unlikely to offer immediate returns, so trimming them back won’t hurt the company’s ability to meet top-line revenue targets.

We suggest avoiding this temptation. It might seem like your core operations have already been cut to the bone through efficiency-related efforts in the 1990s and 2000s, but many companies still have ample resources focused on efforts that are unlikely to create long-term strategic advantage. It is probably impossible to avoid a short-term crunch, so why derail long-term competitive advantage in a misguided attempt to avoid the unavoidable?

That’s not to suggest you should spend innovation dollars thoughtlessly. It is important to safeguard efforts with the most long-term potential, while also ruthlessly pruning efforts that aren’t going to pay off.

No. 2: Push For Diversity

If the economic climate is sour enough, innovation has to be rationalized. A company’s first inclination may be to prioritize short-term efforts that promise immediate payback over longer-term efforts with more questionable payback.

The problem here is twofold. First, if you don’t invest in the long term, you increase the odds you’ll be tempted to rationalize innovation efforts based on past performance. The right guide for decisions isn’t performance, it is potential. Incremental advancements that might have provided blockbuster returns in the past might not provide such returns in the future. If the advancement isn’t meaningful to customers, they won’t pay for it.

Of course, if your analysis shows there is headroom to expand existing products and services, by all means, focus innovation efforts on exploiting that potential. But remember what the mutual fund prospectuses tell us: “Past performance is no guarantee of future results.” Focusing too much on the core business can lead companies smack dab into the roots of the innovator’s dilemma, where they get diminishing returns from investments while missing great growth opportunities emerging in the fringes of their markets or in completely new ones.

No. 3: Become Ruthless At Pruning

One of our favorite innovation stories involves a newspaper company’s 1990s foray on to the Internet. The newspaper’s editor reflected, “Given the pace of our expansion, I don’t think we made mistakes fast enough, and we didn’t learn from them often enough. The problem wasn’t just turning [the experiments] on … it was turning them off.”

Many leaders will tell us they simply don’t have the capacity to innovate. When we look at their innovation pipelines, however, we notice something interesting. All innovation resources are allocated to existing projects, many of which have been going on for years without much real progress. The resources are there, but are being spent on efforts that are very unlikely to pay off.

We call this a “zombie portfolio,” one full of “walking dead” projects. When resources are scarce, companies have to become world-class at identifying when it is time to pull the plug.

We ask four simple questions to determine if it is time for a project to be put to rest:

–How much risk remains?

–What is the cost of the next round of tests?

–How much learning will those tests provide?

–What is the upside potential of the opportunity?

When you can’t shake residual risk, when tests grow increasingly expensive and learning increasingly scarce, and when it’s getting harder to see the upside potential, it might be time to move on. Make these decisions rapidly, remembering that you kill projects, not people.

Continuing to prioritize innovation efforts in recessionary periods requires strong senior leadership. The overwhelming tendency is to slash resources, shut down long-term investments and focus on incremental improvements. Taking the wrong actions can sharply inhibit a company’s ability to reach its long-term strategic objectives. Approaching the problem in the right way can allow companies to do more with less and continue to move forward.

Excerpted from a recent issue of the newsletter Strategy & Innovation. Scott D. Anthony is president of Innosight and co-author of The Innovator’s Guide to Growth. Leslie Feinzaig is a senior associate at Innosight.

Click here for more information on Clayton Christensen and his firm’s monthly newsletter, Strategy & Innovation.